Forever busting the myth that real estate lenders have no control over sustainability-based outcomes, the 2018 GRESB Debt Results provide further evidence of advancing ESG integration by leading banks and private equity funds.The 2018 GRESB Debt participant group revealed three accelerating ESG trends – enhanced risk management techniques, targeted financing programs, and improved portfolio monitoring – that are redefining industry best practice in real estate lending.
Six multi-national banks along with 18 private equity real estate debt funds and one mortgage REIT joined the effort to benchmark their ESG programs, procedures and policies. Nearly all of the 2018 responses highlighted the continued integration of ESG themes during due diligence, developing portfolio-based targets, and formalizing KPI tracking.
The 2018 results reveal 3 ESG trends that are redefining industry best practice in real estate lending: enhanced risk management techniques, targeted financing programs and improved portfolio monitoring.
1. Enhanced Risk Management: Participants affirm systematic progress integrating and tracking ESG metrics within risk management processes. Loan due diligence remains focused on the efficient use of third-party reports and asset-based risk attributes, to include an expanded set of environmental and social risk checks. Leading lenders use tilize ESG-scorecards for Investment / Credit Committee decisions, then monitor and update borrower- and asset-specific criteria over the course of the loan.
2. Targeted Financing Programs: GRESB noted an increase in targeted property improvement financing, with ‘green retrofits’ featured as a recurring theme. Multiple lenders aim to provide additional property improvement financing that yields positive environmental impacts. Most lenders implement on a case-by-case basis; progressive lenders tie financing requirements to ESG-related metrics and outputs. Europe’s growing regulatory push for mandatory energy rating thresholds is clearly driving action.
3. Improved Portfolio Monitoring: The scope and sophistication of post-close loan monitoring tools is the most notable 2018 trend. Real estate lenders are gathering material ESG metrics, tracking portfolio exposures through increased data collection frequency, and using this information to further refine lending criteria. Several respondents highlighted how ESG metrics are feeding into internal risk exposure notification systems, and informing borrower track record for property improvement loans.
Integrating ESG: Plan-Do-Check-Act
Turning objectives into metrics
Sustainability objectives matter, but high-level goals become mere platitudes unless backed by tactical implementation.
A strong majority plurality of GRESB Debt participants [92%] maintain internal ESG commitments in real estate lending including a growing number with specific sustainability-related objectives. A significant number of lenders now report tracking quantified metrics and targeted KPIs. It’s nNotable that, GRESB Debt participants who reported no KPIs the prior year made great strides finalizing their set of ESG metrics for tracking portfolio risks and impacts.
Lenders exhibit one of three sophistication profiles :
- Broad Statements | No Commitments
- Clear Objectives | No Metrics
- Established Targets | Trackable ESG KPIs
GRESB observes a ladder-effect whereby top-scoring lenders translate broad corporate objectives into identifiable targets for the real estate lending group — containing clear metrics and quantifiable outcomes.
Lenders find that moving ahead with ESG integration programs requires long-term, cross-functional thinking. The GRESB Debt framework provides a pathway through its ‘Plan-Do-Check-Act’ approach.
The 2018 Results indicate most GRESB participants are currently focused on the ‘Do’ and ‘Check’ quadrants, and only beginning to prioritize ‘Plan’ and ‘Act’.
Dedicated financing programs and ESG-related due diligence scorecards [‘Do’] are in evidence, with varying levels of integration at the borrower and asset level. A clear majority of lenders estimate exposure to long-term ESG risks including systematic portfolio updates [‘Check’]; however, there are strong differences in analysis scope, and breadth of topics addressed.
GRESB Debt 2018 scoring leaders stand out by their advanced data capture and analytical techniques along multiple asset-level and borrower KPIs, and can better track their loan portfolio.
GRESB also observes lenders with higher scores exhibit a comprehensive plan that includes a sustainable lending policy, ESG Scorecards, and asset-based thresholds [‘Plan’]. Top scoring banks and debt funds alike match targets with due diligence checklists used by loan committees. Portfolio monitoring remains consistent, tracking these KPI metrics over the course of each loan.
Enacting and enforcing asset-level performance covenants [‘Act’] is an emerging trend. Performance covenants are predominantly used for underperforming assets or assets that are going through the major renovation.
ESG in Loan Underwriting
One-and-done vs. portfolio ESG tracking
Streamlined underwriting data collection and systematic portfolio monitoring are critical to integrating ESG into real estate lending. Success relies on equal attention on two components:
- comprehensive borrower review
- asset-level attributes
Leading lenders maintain distinct ESG underwriting techniques tailored to borrowers and property collateral. Tracking ESG KPIs and portfolio impacts offers opportunity to significantly upgrade persistent ‘lend-and-forget’ risk management techniques.
Management matters, particularly with real asset investments where hidden risks can accumulate. A borrower’s ESG track record matching objectives to actions, then delivering high performing energy/water efficient assets positively impacts borrower risk profile. Quality borrowers maintain ESG commitments and disclose performance metrics, often including multiple certified buildings to their credit.
Ultimately asset quality, market position and operating efficiency play a significant part in minimizing loan default risk and maintaining portfolio yields. Top scoring lenders use ESG scorecards in tandem with third-party reports; bi-directional integration is key to elevating important risk metrics. Asset attributes that anchor the ESG scorecard include energy/water consumption and ratings, green building certifications, onsite renewable energy, proximity to multi-modal transit, and indoor environmental quality.
A persistent management gap stems from real estate lenders performing borrower / asset assessments during loan underwriting, but not following up post-loan to reassess and reaffirm straightforward issues including borrower misconduct, asset operating performance history, energy ratings or similar issues.
Loan Scorecard: Sources & Attributes
ESG in due diligence
Real estate lenders require a series of reports during transaction due diligence. Integrating sustainability requires lenders to identify key ESG metrics, assure third party service providers properly include the metrics in their final work, then be prepared to apply these ESG metrics across multiple decision points. In particular, property condition assessments and valuation assignments that specifically incorporate sustainability attributes during contract scoping provide lenders greater decision information used to support risk analysis, loan decisions and downstream loan portfolio monitoring.Most real estate lenders base their risk underwriting approach on minimum requirements for building condition assessments and research into environmental conditions, including contamination. Detailed property audits that cover ESG topics including energy consumption, asset resilience, and green building ratings uncover hidden risks while providing greater decision context for investment committee members. GRESB Debt 2018 results show significant differences amongst participants regarding the quality, rigor and use of due diligence information.
Advanced participants bundle third-party reports, sustainability attributes and asset-level metrics and combine the details to inform three borrower profile types:
- insufficient ESG track record, lacking company policies and asset performance metrics
- sufficient managerial commitment but no asset impact / performance tracking
- well-balanced organizational targets and demonstrated asset-level performance
Borrowers with no ESG track record are being nudged to act. Pledges and promises are easy to craft – tracking asset impacts requires data on outcomes. Lenders signaled preference for borrowers with a track record of organizational targets backed up by a portfolio of well-run, efficient operating assets.
GRESB notes as lenders deepen their ESG due diligence integration, debt providers can assert more control to achieve collateral-based outcomes. Some banks request borrowers to report ESG impact metrics as demonstration of their ability to improve troubled assets.During due diligence, borrowers are asked to produce asset sustainability plans, energy audits and retrofit feasibility budgets as appendices to loan documents.
Climate change risk continues to gain traction in loan analysis, with more private equity funds taking a closer look at natural hazard exposures. The United Kingdom’s MEES energy efficiency legislation came into effect in 2018 – lenders responded by increasing their regulatory risk analysis with a specific eye to asset energy ratings. As more EU countries adopt advanced regulatory schemes to deliver on the UNFCCC Paris Agreement commitments and the European Commission’s action plan on sustainable finance, GRESB anticipates increased pressure on real estate lenders to measure and track additional risk-specific KPIs.
Emerging Topic: Asset Valuation
Lender Scope of Work
An emergent topic in the 2018 GRESB Debt Results is the application of sustainability to asset valuation practices. Lenders understand how operating efficiencies protect collateral value, and are keen to make loans backed by better quality assets.
Lenders are beginning to instruct valuation professionals to more clearly apply sustainability checklists to the subject property and comparables, then make appropriate adjustments to inform loan value.
Close to half of GRESB participants require valuation professionals to include sustainability-related metrics in the final valuation report.
The RICS Red Book requirements (VPAG8 Para 2.6.c) are most-often criteria cited by European Union participants. In the US, the Appraisal Foundation ABP Advisory #9 provides similar guidance. All GRESB participants report selecting the valuer for the assignment is based on demonstrated sustainability expertise.
The top GRESB scoring participants use the valuation instruction letter as a way to secure valuable metrics used in ESG due diligence scorecards during investment committee. Top reported metrics include building certifications; operating efficiency data; onsite renewable energy [existing and potential]; indoor health and well-being attributes; and community relations / connection to surrounding neighborhood.
The growing number buildings with the EU’s EPC energy ratings and/or green building ratings [BREEAM, Green Star, LEED, etc] brings greater transparency and context to asset attributes. Ratings remain a highly useful information source, providing market signals and critical details that further differentiate an asset’s economic prospects.
Many advanced lenders have already integrated these references into their annual scoping agreements with evaluator firms. At minimum, participants identify sustainability metrics / themes applicable to each valuation assignment.
Best Practice: Targeted Financing
Programming Targeted Financing
Targeted financing is gaining traction as banks look to integrate loan origination programs with green loans, green bond syndications and securitizations.
Nearly all GRESB participants provide financing to improve environmental and/or social impacts. However, banks vs their private equity counterparts exhibit vastly different approaches.
It’s more common for private equity lenders to apply an ad hoc approach, offering additional proceeds to borrowers for energy/water efficiency as part of a larger value-add asset strategy. Leading banks maintain specific loan programs for efficiency measures that can be tapped as part of a comprehensive financing package.
Financing Asset Improvements
Energy efficiency measures remain the most financed improvement by commercial real estate lenders. Participants rely on two distinctive metrics – asset energy rating and overall energy consumption – requiring prior years data to set baseline.
Unsurprisingly, GHG emissions is another widely-used improvement measure used by the vast majority of EU-based GRESB participants.
As carbon footprinting gains further traction and the TCFD framework discussions advance, GRESB expects a wider range of real estate lenders to focus on GHG emissions as a financing measure.
Water efficiency was notable as the biggest year-on-year change – more than half of 2018 participants confirmed they actively finance water efficiency improvements.
The idea of “Circular Economy” – designing waste out, minimising negative impacts, driving innovation – is an advanced theme. Several banks report heightened focus on material recycling, advanced refurbishment technologies, and minimising grid reliance.
While a Circular Economy approach remains a leading-edge topic, these concepts yield positive impacts across multiple KPIs and should attract additional early adopters.